10/1/2019

Chapter 6

Designing Global Supply Chain

Networks

Sharfuddin Lisan
BBA,BA(Hons)English, DSC,DHRM,MA,
MHRM(DU),
PGDSCM, MBA(SCM)-Canada
,lisanbd@ymail.com, info@bihrm.org
01731822888

Learning Objectives

• Identify factors that need to be included in total cost when making

global sourcing decisions.

• Define uncertainties that are particularly relevant when designing

global supply chains.

• Explain different strategies that may be used to mitigate risk in

global supply chains.

• Understand decision tree methodologies used to evaluate supply

chain design decisions under uncertainty.

1
 10/1/2019

Impact of Globalization on Supply Chain

Networks

• Opportunities to simultaneously grow revenues and decrease costs

• Accompanied by significant additional risk

• Difference between success and failure often ability to incorporate

suitable risk mitigation into supply chain design

• Uncertainty of demand and price drives the value of building

flexible production capacity

Impact of Globalization on Supply Chain

Networks

Risk Factors Percentage of Supply Chains Impacted

Natural disasters 35
Shortage of skilled resources 24
Geopolitical uncertainty 20
Terrorist infiltration of cargo 13
Volatility of fuel prices 37
Currency fluctuation 29
Port operations/custom delays 23
Customer/consumer preference shifts 23
Performance of supply chain partners 38
Logistics capacity/complexity 33
Forecasting/planning accuracy 30
Supplier planning/communication issues 27
Inflexible supply chain technology 21

Table 6-1

2
 10/1/2019

The Offshoring Decision: Total Cost

• Comparative advantage in global supply chains

• Quantify the benefits of offshore production along with the reasons

• Two reasons for offshoring failure

Focusing exclusively on unit cost rather than total cost
Ignoring critical risk factors

The Offshoring Decision: Total Cost

Performance Activity Impacting Impact of Offshoring

Dimension Performance
Order communication Order placement More difficult communication
Supply chain visibility Scheduling and expediting Poorer visibility

Raw material costs Sourcing of raw material Could go either way

depending on raw material
sourcing
Unit cost Production, quality (production Labor/fixed costs decrease;
and transportation) quality may suffer
Freight costs Transportation modes and Higher freight costs
quantity
Taxes and tariffs Border crossing Could go either way

Supply lead time Order communication, supplier
production scheduling,
production time, customs,
transportation, receiving
Lead time increase results in
poorer forecasts and higher
inventories
Table 6-2

3
 10/1/2019

The Offshoring Decision: Total Cost

Performance Activity Impacting Impact of Offshoring

Dimension Performance
On-time delivery/lead Production, quality, customs, Poorer on-time delivery and
time uncertainty transportation, receiving increased uncertainty
resulting in higher inventory
and lower product availability
Minimum order quantity Production, transportation Larger minimum quantities
increase inventory
Product returns Quality Increased returns likely

Inventories Lead times, inventory in transit Increase

and production
Working capital Inventories and financial Increase
reconciliation
Hidden costs Order communication, invoicing Higher hidden costs
errors, managing exchange rate
risk
Stock-outs Ordering, production, Increase
transportation with poorer
visibility Table 6-2

The Offshoring Decision: Total Cost

• A global supply chain with offshoring increases the length and

duration of information, product, and cash flows

• The complexity and cost of managing the supply chain can be

significantly higher than anticipated

• Quantify factors and track them over time

• Big challenges with off shoring is increased risk and its potential
impact on cost

4
 10/1/2019

The Offshoring Decision: Total Cost

• Key elements of total cost

Supplier price
Terms
Delivery costs
Inventory and warehousing
Cost of quality
Customer duties, value added-taxes, local tax incentives
Cost of risk, procurement staff, broker fees, infrastructure, and
tooling and mold costs
Exchange rate trends and their impact on cost

Risk Management in Global Supply Chains

• Risks include supply disruption, supply delays, demand

fluctuations, price fluctuations, and exchange-rate fluctuations

• Critical for global supply chains to be aware of the relevant risk

factors and build in suitable mitigation strategies

10

5
 10/1/2019

Risk Management in Global Supply Chains

Category Risk Drivers

Disruptions Natural disaster, war, terrorism
Labor disputes
Supplier bankruptcy
Delays High capacity utilization at supply source
Inflexibility of supply source
Poor quality or yield at supply source
Systems risk Information infrastructure breakdown
System integration or extent of systems
being networked
Forecast risk Inaccurate forecasts due to long lead
times, seasonality, product variety, short
life cycles, small customer base
Information distortion
Table 6-3

11

Risk Management in Global Supply Chains

Category Risk Drivers

Intellectual property risk Vertical integration of supply chain
Global outsourcing and markets
Procurement risk Exchange-rate risk
Price of inputs
Fraction purchased from a single source
Industry-wide capacity utilization
Receivables risk Number of customers
Financial strength of customers
Inventory risk Rate of product obsolescence
Inventory holding cost
Product value
Demand and supply uncertainty
Capacity risk Cost of capacity
Capacity flexibility
Table 6-3

12

6
 10/1/2019

Risk Management in Global Supply Chains

• Good network design can play a significant role in mitigating

supply chain risk

• Every mitigation strategy comes at a price and may increase

other risks

• Global supply chains should generally use a combination of

rigorously evaluated mitigation strategies along with financial
strategies to hedge uncovered risks

13

Risk Management in Global Supply Chains

Risk Mitigation Tailored Strategies

Strategy
Increase capacity Focus on low-cost, decentralized capacity
for predictable demand. Build centralized
capacity for unpredictable demand.
Increase decentralization as cost of
capacity drops.
Get redundant suppliers More redundant supply for high-volume
products, less redundancy for low-volume
products. Centralize redundancy for low-
volume products in a few flexible
suppliers.
Increase responsiveness Favor cost over responsiveness for
commodity products. Favor responsiveness
over cost for short–life cycle products.

Table 6-4

14

7
 10/1/2019

Risk Management in Global Supply Chains

Risk Mitigation Tailored Strategies

Strategy
Increase inventory Decentralize inventory of predictable, lower value
products. Centralize inventory of less predictable,
higher value products.
Increase flexibility Favor cost over flexibility for predictable, high-
volume products. Favor flexibility for unpredictable,
low-volume products. Centralize flexibility in a few
locations if it is expensive.
Pool or aggregate demand Increase aggregation as unpredictability grows.
Increase source capability Prefer capability over cost for high-value, high-risk
products. Favor cost over capability for low-value
commodity products. Centralize high capability in
flexible source if possible.

Table 6-4

15

Flexibility, Chaining, and Containment

• Three broad categories of flexibility

New product flexibility
 Ability to introduce new products into the market at a rapid
rate
Mix flexibility
 Ability to produce a variety of products within a short period of
time
Volume flexibility
 Ability to operate profitably at different levels of output

16

8
 10/1/2019

Flexibility, Chaining, and Containment

Figure 6-1

17

Flexibility, Chaining, and Containment

• As flexibility is increased, the marginal benefit derived from the

increased flexibility decreases
With demand uncertainty, longer chains pool available capacity
Long chains may have higher fixed cost than multiple smaller
chains
Coordination more difficult across with a single long chain

• Flexibility and chaining are effective when dealing with demand

fluctuation but less effective when dealing with supply disruption

18

9
 10/1/2019

Discounted Cash Flow Analysis

• Supply chain decisions should be evaluated as a sequence of cash

flows over time

• Discounted cash flow (DCF) analysis evaluates the present value

of any stream of future cash flows and allows managers to
compare different cash flow streams in terms of their financial
value

• Based on the time value of money – a dollar today is worth more

than a dollar tomorrow

19

Discounted Cash Flow Analysis

1
Discountfactor 
1 k
t
T
 1 
NPV  C 0     Ct
t 1  1  k 
where
C0, C1,…,CT is stream of cash flows over T periods
NPV = net present value of this stream

k = rate of return
• Compare NPV of different supply chain design options
• The option with the highest NPV will provide the greatest
financial return

20

10
 10/1/2019

Trips Logistics Example

• Demand = 100,000 units

• 1,000 sq. ft. of space for every 1,000 units of demand
• Revenue = $1.22 per unit of demand
• Sign a three-year lease or obtain warehousing space on the spot
market?
• Three-year lease cost = $1 per sq. ft.
• Spot market cost = $1.20 per sq. ft.
• k = 0.1

21

Trips Logistics Example

Expected annual profit if warehouse = 100,000 x $1.22

space is obtained from the spot – 100,000 x $1.20
market = $2,000

C1 C2
NPV(No lease)  C 0  
1 k (1 k) 2
2,000 2,000
 2,000    $5,471
1.1 1.12

22

11
 10/1/2019

Trips Logistics Example

Expected annual profit with = 100,000 x $1.22

three year lease – 100,000 x $1.00
= $22,000

C1 C2
NPV(Lease)  C 0  
1 k (1 k) 2
22,000 22,000
 22,000    $60,182
1.1 1.12

• NPV of signing lease is $60,182 – $5,471 = $54,711 higher

than spot market

23

Using Decision Trees

• Many different decisions

Should the firm sign a long-term contract for warehousing space
or get space from the spot market as needed?
What should the firm’s mix of long-term and spot market be in
the portfolio of transportation capacity?
How much capacity should various facilities have? What fraction
of this capacity should be flexible?

24

12
 10/1/2019

Using Decision Trees

• During network design, managers need a methodology that allows

them to estimate the uncertainty in demand and price forecast
and incorporate this in the decision-making process

• Most important for network design decisions because they are

hard to change in the short term

25

Basics of Decision Tree Analysis

• A decision tree is a graphic device used to evaluate decisions under

uncertainty
Identify the number and duration of time periods that will be
considered
Identify factors that will affect the value of the decision and are
likely to fluctuate over the time periods
Evaluate decision using a decision tree

26

13
 10/1/2019

Decision Tree Methodology

• Identify the duration of each period (month, quarter, etc.) and

the number of periods T over which the decision is to be
evaluated
• Identify factors whose fluctuation will be considered
• Identify representations of uncertainty for each factor
• Identify the periodic discount rate k for each period
• Represent the decision tree with defined states in each period as
well as the transition probabilities between states in successive
periods
• Starting at period T, work back to Period 0, identifying the
optimal decision and the expected cash flows at each step

27

Decision Tree – Trips Logistics

• Three warehouse lease options

Get all warehousing space from the spot market as needed
Sign a three-year lease for a fixed amount of warehouse space
and get additional requirements from the spot market
Sign a flexible lease with a minimum charge that allows variable
usage of warehouse space up to a limit with additional
requirement from the spot market

28

14
 10/1/2019

Decision Tree – Trips Logistics

• 1000 sq. ft. of warehouse space needed for 1000 units of demand
• Current demand = 100,000 units per year
• Binomial uncertainty: Demand can go up by 20% with
p = 0.5 or down by 20% with 1 – p = 0.5
• Lease price = $1.00 per sq. ft. per year
• Spot market price = $1.20 per sq. ft. per year
• Spot prices can go up by 10% with p = 0.5 or down by 10% with
1 – p = 0.5
• Revenue = $1.22 per unit of demand
• k = 0.1

29

Revenue Cost Profit

Trips Logistics Decision Tree 144,000 × 1.22 144,000 × 1.45 –$33,120

Period 2
Period 1 D=144
–$33,120
Period 0 p=$1.45
0.25
Probability * All D=144
0.25 $4,320
D=120 p=$1.19
- $22,909 - $12,000 0.25 0.25
p=$1.32 D=96 –$22,080
DCF:
- 10,909 p=$1.45
0.25
D=144 $36,000
$32,073 $16,800
0.25 D=120 p=$0.97
DCF: p=$1. 08
D=100 15,273 D=96
$2,880
p=$1.20 0.25 p=$1.19
- $15,273 -$8,000
DCF: D=80 D=96
$24,000
- 7,273 p=$1.32 p=$0.97

D=64
$21,382 $11,200 0.25 –$14,720
DCF: D=80 p=$1.45
10,182
p=$1.08 D=64
$1,920
p=$1.19
D=64
$16,000
PVEP(D = 100, p = 1.20,1) = EP(D = 100, p = 1.20,0) / (1 + k) p=$0.97
Probability * All = $3,818 / (1.1) = $3,471 {DCF}

P(D=100, p=1.20,0)=100,000x1.22–100,000x1.20+PVEP(D = 100, p = 1.20,0)

Period 0 Profit(2000) = $2,000 + $3,471 = $5,471

30

15
 10/1/2019

Decision Tree – Trips Logistics

• Analyze the option of not signing a lease and using the spot
market

• Start with Period 2 and calculate the profit at each node

For D = 144, p = $1.45, in Period 2:
C(D = 144, p = 1.45,2) = 144,000 x 1.45
= $208,800
P(D = 144, p = 1.45,2) = 144,000 x 1.22
– C(D = 144, p = 1.45, 2)
= 175,680 – 208,800
= –$33,120

31

Decision Tree – Trips Logistics

Cost Profit
Revenue C(D =, p =, 2) P(D =, p =, 2)
D = 144, p = 144,000 × 1.22 144,000 × 1.45 –$33,120
1.45
D = 144, p = 144,000 × 1.22 144,000 × 1.19 $4,320
1.19
D = 144, p = 144,000 × 1.22 144,000 × 0.97 $36,000
0.97
D = 96, p = 1.45 96,000 × 1.22 96,000 × 1.45 –$22,080
D = 96, p = 1.19 96,000 × 1.22 96,000 × 1.19 $2,880
D = 96, p = 0.97 96,000 × 1.22 96,000 × 0.97 $24,000
D = 64, p = 1.45 64,000 × 1.22 64,000 × 1.45 –$14,720
D = 64, p = 1.19 64,000 × 1.22 64,000 × 1.19 $1,920
D = 64, p = 0.97 64,000 × 1.22 64,000 × 0.97 $16,000 Table
6-5

32

16
 10/1/2019

Decision Tree – Trips Logistics

• Expected profit at each node in Period 1 is the profit during Period

1 plus the present value of the expected profit in Period 2

• Expected profit EP(D =, p =, 1) at a node is the expected profit

over all four nodes in Period 2 that may result from this node

• PVEP(D =, p =, 1) is the present value of this expected profit and

P(D =, p =, 1), and the total expected profit, is the sum of the
profit in Period 1 and the present value of the expected profit in
Period 2

33

Decision Tree – Trips Logistics

• From node D = 120, p = $1.32 in Period 1, there are four

possible states in Period 2

• Evaluate the expected profit in Period 2 over all four states

possible from node D = 120, p = $1.32 in Period 1 to be
EP(D = 120, p = 1.32,1) = 0.2 x [P(D = 144, p = 1.45,2) +
P(D = 144, p = 1.19,2) + P(D = 96, p = 1.45,2) +
P(D = 96, p = 1.19,2)
= 0.25 x [–33,120 + 4,320 – 22,080 + 2,880]
= –$12,000

34

17
 10/1/2019

Decision Tree – Trips Logistics

• The present value of this expected value in Period 1 is

PVEP(D = 120, p = 1.32,1)
= EP(D = 120, p = 1.32,1) / (1 + k)
= –$12,000 / (1.1)
= –$10,909
• The total expected profit P(D = 120, p = 1.32,1) at node D =
120, p = 1.32 in Period 1 is the sum of the profit in Period 1 at
this node, plus the present value of future expected profits
possible from this node
P(D = 120, p = 1.32,1) = 120,000 x 1.22 – 120,000 x 1.32 +
PVEP(D = 120, p = 1.32,1)
= –$12,000 – $10,909 = –$22,909

35

Decision Tree – Trips Logistics

• For Period 0, the total profit P(D = 100, p = 120, 0) is the sum of
the profit in Period 0 and the present value of the expected profit
over the four nodes in Period 1
EP(D = 100, p = 1.20,0) = 0.25 x [P(D = 120, p = 1.32,1) +
P(D = 120, p = 1.08,1) + P(D = 96, p = 1.32,1) +
P(D = 96, p = 1.08,1)]
= 0.25 x [–22,909 + 32,073 – 15,273) + 21,382]
= $3,818

36

18
 10/1/2019

Decision Tree – Trips Logistics

PVEP(D = 100, p = 1.20,1) = EP(D = 100, p = 1.20,0) / (1 + k)

= $3,818 / (1.1) = $3,471

P(D = 100, p = 1.20,0) = 100,000 x 1.22 – 100,000 x 1.20 +

PVEP(D = 100, p = 1.20,0)
= $2,000 + $3,471 = $5,471

• Therefore, the expected NPV of not signing the lease and

obtaining all warehouse space from the spot market is given by
NPV(Spot Market) = $5,471

37

Decision Tree – Trips Logistics

• Fixed Lease Option

Table 6-6

38

19
 10/1/2019

Revenue Cost Profit

P(D =, p =, 1)
= D x 1.22 – (100,000 x 1 + Decision Tree 144,000 × 1.22 144,000 × 1.45 –$33,120

Sx
p) + EP(D =, p =
,1)(1 + k) $11,880

DCF: EPP/RR + spot price Probability * All

$23,320
$35,782 $17,360
DCF:
35782+
20000 $33,000

$45,382 $22,640 $17,120

DCF:
22,742+
20000
$17,120
–$4,582 - $2,400

DCF:
-2182 $17,120

–$4,582 - $2,400
DCF:
–$21,920
- 2182

–$21,920
PVEP(D = 100, p = 1.20,1) = EP(D = 100, p = 1.20,0) / (1 + k)
= 18,000/1.1 = $16,364 {DCF}
–$21,920
Figure 6-2
P(D=100, p=1.20,0)=100,000x1.22–100,000x1.20+PVEP(D = 100, p = 1.20,0)
Period 0 Profit = $22,000 + $16364 = $38,364

39

Decision Tree – Trips Logistics

Profit P(D =, p =, 2)
Warehouse Space = D x 1.22 – (100,000
Node Leased Space at Spot Price (S) x 1 + S x p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880

D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320

D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000

D = 96, p = 1.45 100,000 sq. ft. 0 sq. ft. $17,120

D = 96, p = 1.19 100,000 sq. ft. 0 sq. ft. $17,120

D = 96, p = 0.97 100,000 sq. ft. 0 sq. ft. $17,120

D = 64, p = 1.45 100,000 sq. ft. 0 sq. ft. –$21,920

D = 64, p = 1.19 100,000 sq. ft. 0 sq. ft. –$21,920

D = 64, p = 0.97 100,000 sq. ft. 0 sq. ft. –$21,920 Table 6-7

40

20
 10/1/2019

Decision Tree – Trips Logistics

P(D =, p =, 1)
Warehouse = D x 1.22 –
Space (100,000 x 1 + S x
at Spot p) + EP(D =, p =
Node EP(D =, p =, 1) Price (S) ,1)(1 + k)
D = 120, p = 1.32 0.25 x [P(D = 144, p = 20,000 $35,782
1.45,2) + P(D = 144, p =
1.19,2) + P(D = 96, p =
1.45,2) + P(D = 96, p =
1.19,2)] = 0.25 x (11,880 +
23,320 + 17,120 + 17,120) =
$17,360
D = 120, p = 1.08 0.25 x (23,320 + 33,000 + 20,000 $45,382
17,120 + 17,120) = $22,640
D = 80, p = 1.32 0.25 x (17,120 + 17,120 – 0 –$4,582
21,920 – 21,920) = –$2,400
D = 80, p = 1.08 0.25 x (17,120 + 17,120 – 0 –$4,582
21,920 – 21,920) = –$2,400 Table 6-8

41

Decision Tree – Trips Logistics

• Using the same approach for the lease option, NPV(Lease) =

$38,364

• Recall that when uncertainty was ignored, the NPV for the lease
option was $60,182

• However, the manager would probably still prefer to sign the

three-year lease for 100,000 sq. ft. because this option has the
higher expected profit

42

21
 10/1/2019

• Flexible Lease Option

Profit P(D =, p =, 2)
Warehouse Warehouse Space = D x 1.22 – (W x 1 + S
Node Space at $1 (W) at Spot Price (S) x p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880

D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320

D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000

D = 96, p = 1.45 96,000 sq. ft. 0 sq. ft. $21,120

D = 96, p = 1.19 96,000 sq. ft. 0 sq. ft. $21,120

D = 96, p = 0.97 96,000 sq. ft. 0 sq. ft. $21,120

D = 64, p = 1.45 64,000 sq. ft. 0 sq. ft. $14,080

D = 64, p = 1.19 64,000 sq. ft. 0 sq. ft. $14,080

D = 64, p = 0.97 64,000 sq. ft. 0 sq. ft. $14,080 Table 6- 9

43

The general manager at Trips Logistics has been offered a

contract in which, for an up-front payment of $10,000,
Trips Logistics will have the flexibility of using between
60,000 sq. ft. and 100,000 sq. ft. of warehouse space at
$1 per square foot per year.

Trips Logistics must pay $60,000 per year for the first
60,000 sq. ft. and can then use up to another 40,000 sq.
ft. on demand at $1 per square foot. The general
manager decides to use decision trees to evaluate
whether this flexible contract is preferable to a fixed
contract for 100,000 sq. ft.

44

22
 10/1/2019

Revenue Cost Profit

P(D =, p =, 1)
= D x 1.22 –
(Wx 1 + S x p) +
Decision Tree 144,000 × 1.22 144,000 × 1.45 –$33,120

EP(D =, p = ,1)(1
+ k)
$11,880

DCF: EPP/RR + spot price Probability * All

$37,600 $19,360
$23,320
DCF:
17600+
20000 $21,120

$47,200 $24,640
$33,000
DCF:
22,400+
24200
$21,120
$33,600 $17,600
DCF:
16000
$21,120
$33,600 $17,600
DCF:
16000
$14,080

$14,080

Figure 6-2
$14,080

45

Decision Tree – Trips Logistics

P(D =, p =, 1)
Warehouse = D x 1.22 – (W
Warehouse Space x 1 + S x p) +
Space at $1 at Spot EP(D =, p = ,1)(1
Node EP(D =, p =, 1) (W) Price (S) + k)
D = 120, 0.25 x (11,880 + 100,000 20,000 $37,600
p = 1.32 23,320 + 21,120 +
21,120) = $19,360
D = 120, 0.25 x (23,320 + 100,000 20,000 $47,200
p = 1.08 33,000 + 21,120 +
21,120) = $24,640
D = 80, 0.25 x (21,120 + 80,000 0 $33,600
p = 1.32 21,120 + 14,080 +
14,080) = $17,600
D = 80, 0.25 x (21,920 + 80,000 0 $33,600
p = 1.08 21,920 + 14,080 +
14,080) = $17,600 Table 6-10

46

23
 10/1/2019

Decision Tree – Trips Logistics

Option Value
All warehouse space from the spot market $5,471
Lease 100,000 sq. ft. for three years $38,364
Flexible lease to use between 60,000 and 100,000 sq. $46,545
ft.
Table 6-11

47

Thanks

48

24